Don't Even Think About Owning Treasury Bonds

Take a hint from the world's largest bond fund.

The disclosure by PIMCO in April that fund manager Bill Gross is betting against Treasury bonds in the Total Return Fund -- the world's largest bond fund -- made a lot of noise. On Friday, Gross told Reuters that he would reverse that bet and start buying Treasuries if the U.S. entered a recession. As Gross ponders his options, we reconsider an allocation to bonds and take a closer look at some other options.

The double-dip as a buy signalWhy even bother speculating about the possibility of recession? Look at the recovery in corporate profits and the resurgence in consumer confidence. It'll never happen ... maybe, maybe not. Although a double-dip recession still looks unlikely to me, the risk is definitely not zero.

Don't rule it outFor proof, just look at the headline on the front page of yesterday's Wall Street Journal: "Home Market Takes a Tumble" (subtitle: Turnaround More Distant After 3% Drop, Steepest Quarterly Decline Since 2008). Moreover, last Friday's employment data were mixed, with unemployment rising from 8.8% to 9% -- the first increase in the unemployment rate since last November. In that murky context, here's how I view U.S. Treasuries right now.

Short term: Uncertainty is exceptionally highJust as with stocks, it's bizarre that Treasury bond volatility, as measured by the Merrill Option Volatility Index, should be approaching four-year lows in this environment. Perhaps it's the result of a bearish consensus on Treasuries; as UBS interest rate strategist Mike Schumacher told The Wall Street Journal recently, "Almost every client we have seen in the last month is short" U.S. Treasuries.

Given the uncertainty associated with the end of QE2 and the weakness of the U.S. economic recovery, I'm very distrustful of any consensus on bonds. You don't get paid on one-way bets unless you're the house, and even Morgan Stanley -- the most bearish of the government bond primary dealers -- is no longer recommending betting against Treasuries (the same goes for Goldman Sachs, which always seems to be on the right side of major reversals). In any case, individual investors have no business making short-term bets on government bonds.

Long-term: From opacity to clarityEven with the 10-year Treasury yielding just 3.16%, yields can still go lower in the short term, which would push bond prices up (price and yield move in opposite directions). However, as we look out over a longer time horizon, yields are unlikely to go anywhere but up (they could remain at current levels over long periods under a Japan-style deflationary scenario, but that looks like a long-odds outcome). As Bill Gross notes: "Treasury yields are currently yielding substantially less than historical averages when compared with inflation."

According to Gross, investors simply aren't being properly compensated to hold Treasury securities; in fact, in his most recent commentary he quantifies the shortfall in yield investors are accepting: one to two percentage points (annually). The implications for individual investors should be clear: The recommended allocation to U.S. Treasury bonds or vehicles such as the iShares Barclays 20+ Year Treasury Bond Fund ETF(NYSE: TLT) is zero (or close to it). But if government bonds are out, what should investors be looking at?

A poor alternative: Precious metalsInvestors who understand the risks of owning Treasury bonds may be tempted to replace their bond allocation with positions in the SPDR Gold Shares(NYSE: GLD) or the iShares Silver Trust(NYSE: SLV) on the basis that these metals are a hard store of value compared to Uncle Sam's IOUs. Unfortunately, investors who follow that logic are stepping out of the fire into the metal frying pan. Even after last week's massacre in commodities, long-term owners of these metals are likely to suffer additional losses.

Prefer high-quality, dividend stocksMy preference is to own real assets that generate cash. Prominent among those are "franchise" stocks that belong to businesses with pricing power. Think pharmaceutical giant Merck(NYSE: MRK), utility Exelon(NYSE: EXC), or defense contractor Lockheed Martin(NYSE: LMT), all of which pay a healthy dividend yield. (If you'd like to track these three inflation-beating stocks using My Watchlist, click here.)

Don't dismiss cash as an optionI've sung the praises of cash in the past. It's not a long-term asset allocation choice, to be sure, but investors shouldn't overlook cash in this environment. Societe Generale strategist Dylan Grice explains why in a recent client note:

Cash has one important endowment which is too frequently unrecognized: a hidden optionality derived from its relative stability. In other words, the holder of cash has an effective option to purchase more volatile assets if and when they become cheap. Thus, a willingness to hold cash when there are no obvious alternatives is the simplest way to 'get long of the tails,' and therefore the original 'long-vol' strategy.

Cash does have at least one prominent fan right now: Bill Gross. At the end of the April, more than one-third (37%) of the $241 billion PIMCO Total Return Fund was in cash.

There are more risks in this market than meet the eye.Watch thisbefore the market crashes.